Economy on the brink as cabinet plans 'bad bank'

GDP figures will show that the country is now officially in a deep recession while new figures on unemployment are set to reveal that the claimant count has soared above 1.15 million, while economists expect more evidence that inflation is turning to deflation.

The Ernst & Young Item Club warns that this week will herald the start of a headlong plunge into the most severe economic contraction since 1931.

But it is also shaping up to be another week of unprecedented action by the Government as the Treasury fights back with further measures to pour more capital into the embattled banking system. As fears grow over further bank failures, policymakers have been holding emergency talks this weekend, with an announcement expected as early as today.

Among the options on the table is the creation of a "bad bank" into which all toxic assets could be poured, although banking sources are sceptical about how the scheme would work. "There is speculation that the bad bank idea is designed purely to help out the Royal Bank," said one source. Also on the cards is a "good bank", potentially Northern Rock, to kick-start lending.

Prime Minister Gordon Brown is demanding the banks come clean on their debts to remove taxpayers' suspicions over the extent of their indebtedness and to help restore confidence.

But analysts believe the Government is preparing for full nationalisation of the banks if these latest measures fail to get the banks to lend.

Economists are declaring that the phoney war, when dire economic forecasts were not backed up by official statistics, is now well and truly over.

"The figures will be diabolical," said Jeremy Batstone-Carr, director of private client research at Charles Stanley. "If we're not in Armageddon by Friday then we are well on a path to it."

GDP figures for the final three months of 2008, published on Friday, are expected to show Britain has entered recession at breakneck speed with a fall of 1.2% compared to the previous three months, when the economy contracted by 0.6%. The technical definition of a recession is two consecutive quarters of negative GDP.

But economists are braced for far worse on the horizon. In its latest report, the Ernst and Young Item Club will warn GDP is likely to contract by 2.7% this year, with a further 0.5% fall in 2010, representing the worst economic slump since the Great Depression of the early 1930s. The research group Global Insight is predicting an even more severe contraction of 2.9% this year.

Unemployment figures, out on Wednesday, will do little to lift the gloom. The number of Britons claiming Jobseeker's Allowance is expected to have soared by a further 83,000 to more than 1.15 million in December as some of the country's best-known companies continue to shed jobs at an alarming rate.

International Labour Organisation data, also out on Wednesday, is expected to show Britain's unemployment rate hit 6.1% between September and November last year. The Item Club warns that overall the recession is now likely to claim 3.25m jobs by the end of 2010.

Scottish policymakers, who had hoped Scotland would fare better than the rest of the UK, are being told to prepare for a loss of 116,600 jobs by the end of next year. Until recently, this forecast by Strathclyde University's Fraser of Allander Institute, had been considered the "worst case scenario", with the more likely figure of 50,000.

But at a presentation last week by DTZ, the property group which is preparing an economic report for Scottish Enterprise, economist John Boyle said the worst case scenario is rapidly becoming the more likely case. "Unfortunately that's the view that is gaining some currency because most economic indicators are heading southwards," he said.

The Bank of England's latest inflation figures on Tuesday will provide some temporary cheer for households when the Consumer Prices Index (CPI) is tipped to come down from 4.1% to 2.6%. But the good news will be short-lived as economists agree Britain will enter a period of potentially damaging deflation this summer. According to Ben Reed, an economist with the Centre for Economics and Business Research (CEBR), deflation is already being felt in many sectors such as the auto industry. "On the more serious aspects of deflation, you are already starting to see that in any case," he said.

The City will welcome further action by the Treasury and the Bank of England to mitigate the worst effects of the recession, but Batstone-Carr of Charles Stanley said the authorities need to keep one eye on how policies introduced now could affect the economy in a few years' time.